This article was originally published in the Association of Business Trial Lawyers (ABTL) - Orange County Report, Volume XX, No. 1, Spring 2018
The proper use of social media, blogging, cloud computing, and crowdfunding are just a few of the ever-growing tech-related issues that have ethical implications for attorneys. We must add to the list the cryptocurrency craze influencing the investment markets. Regardless of your personal feelings towards Bitcoin, Ethereum, Ripple, etc., clearly something big is happening, and attorneys need to pay attention – particularly because attorney ethics panels are starting to take notice and significant ethical implications exist for any attorney who accepts fees in cryptocurrency.
What is Cryptocurrency?
If you ask a typical attorney to explain cryptocurrency, they will probably understand that: (1) it is a form of digital currency that makes it easier to transfer funds between two parties; (2) it is not “issued” or “backed” by any central bank or authority, rendering it less prone to government interference and protection; and (3) the nature of the transactions makes them private and confidential. But the understanding typically ends there because of cryptocurrency’s novelty and overwhelming technology. Having a basic understanding of how this new technology works is important to understand why so many people across industries consider it revolutionary.
Central to cryptocurrencies like Bitcoin is the blockchain it uses to store an online ledger of all the transactions that have ever been conducted using the currency. The best way to imagine the system in place is to think of a highly encrypted, publicly available “spreadsheet” that is not stored in any single location, but is shared and duplicated by millions of computers. As transactions take place, the spreadsheet is regularly updated and continually reconciled. The completed transaction is recorded into blocks and eventually into the blockchain. The cryptocurrency’s users themselves validate the transactions whenever one person pays another for goods or services. The clear benefit of the technology is that the transactions eliminate the need for a third party to process or store payments. Consequently, cryptocurrency transactions are done with minimal processing fees and avoid the fees charged by most banks.
While everyday speculators may invest in cryptocurrency, it is the proliferation of blockchain technology that has led to the boom in this industry. Apart from its use in cryptocurrency transactions, other industries and governments are finding many potential uses for blockchain’s conceptual framework as a secure, digital alternative to more expensive, bureaucratic, time-consuming processes. In healthcare, for example, blockchain infrastructure is now being used for clinical trial data, regulatory compliance, and electronic medical records.
What Are the Risks and Benefits Associated with Cryptocurrency Transactions?
There are, of course, a litany of reasons why attorneys should avoid cryptocurrency transactions with clients. For starters, the market (where growth is based almost entirely on speculation) is prone to wild price swings. In January 2017 alone, the price of one Bitcoin fluctuated between highs of $17,101 and lows of $9,477. From December 16, 2017 to February 6, 2018, Bitcoin tumbled again from $19,343 to $6,914. Volatility remains one of its defining characteristics as an investment.
Fueling this volatility is the hack-prone history of the industry. While the cryptocurrency industry is not alone in its exposure to hacking, unlike with hacks involving traditional financial institutions, it is often impossible to recover stolen cryptocurrency because blockchain transactions are irreversible.
Just this past January, the Japan-based crypto exchange Coincheck was the target of hackers who stole ¥58 billion ($534 million dollars) in customer deposits of NEM, a less well known digital currency launched in early 2015. The hack, reportedly the largest cryptocurrency security breach in history, affected 260,000 exchange customers and accounted for roughly 6% of NEM’s entire market capitalization.
The risks can be multiplied with newer cryptocurrencies. In fact, a recent report by Ernst & Young suggests that over 10 percent of the funds generated by initial coin offerings (approximately $400 million) are either misplaced or seized by hackers. See Ernst & Young, Big risks in ICO market: flawed token valuations, unclear regulations, heightened hacker attention and congested networks (Jan. 22, 2018). These attacks exploit coding flaws in new cryptocurrencies, which can be rushed to market without meaningful review. While law firms will typically not have significant amounts in an exchange and can protect themselves from being directly targeted by hackers, no one is immune from the effects of a large hack, which as NEM’s pricing after the hacking incident shows, can result in wild price swings. Wide-scale hacking can also indirectly create doubt in the viability of the targeted cryptocurrency or even the crypto market as a whole.
Notwithstanding, a growing number of law firms are willing to look past these potential risks and accept payment in Bitcoin and other cryptocurrency. Most firms do so as a client driven business decision and not as an investment. Among them are firms who may have a large client base in the growing blockchain industry and want to show their clients that they have a vested interest in the industry or believe in the potential of the technology. Law firms with high-net-worth clients in the tech industry may increasingly find themselves with clients who are cryptocurrency proponents with the majority of their net worth consisting of Bitcoin. Law firms may also have international clients who find it more efficient to transact in cryptocurrency. Other firms may want to delve into Bitcoin for political reasons, and to show their support for the unregulated nature of cryptocurrency.
Are There Ethical Implications for Attorneys When Dealing with Cryptocurrency Transactions?
Yes. California Rule of Professional Conduct 3-300 prohibits attorneys from entering into a business transaction with a client or knowingly acquiring an ownership, possessory, security, or other pecuniary interest adverse to a client unless the transaction or acquisition is fair and fully disclosed in writing with the client’s written consent. Rule of Professional Conduct 3-110 also requires attorneys to have “sufficient learning and skill” before taking on an engagement. Cryptocurrency implicates both rules and cryptocurrency is now coming to the attention of attorney ethics panels.
Last September, the Nebraska Supreme Court’s ethics committee issued an advisory opinion that discussed in detail how attorney ethics rules may apply to transactions in digital currency. See Nebraska Supreme Court Ass’n Advisory Comm., Op. 17-03, 9/11/17. While the brief, 10-page opinion can at times be lacking in details, it provides commonsense advice that all attorneys can easily follow.
Before the Nebraska committee were three questions:
- May an attorney receive digital currencies such as bitcoin as payment for legal services?
- May an attorney receive digital currencies from third parties as payment for the benefit of a client’s account?
- May an attorney hold digital currencies in trust or escrow for clients?
First, the committee noted that attorneys are expressly allowed to accept property like cryptocurrency in payment of services. Given the fluctuations in value, the committee instructed attorneys to immediately value or convert cryptocurrency to U.S. dollars upon receipt and to credit the client’s account accordingly. The purpose of this requirement is to protect the client against wild fluctuations in value that could result in charging unreasonable fees. Although not directly addressed by the committee, doing so makes clear that market volatility risk is transferred to the attorney upon receipt. Immediately converting the cryptocurrency to U.S. dollars also limits the risk of the cryptocurrency losing significant value; which may otherwise place the attorney in an ethical dilemma of agreeing to work for property that is now worthless.
Critically important is notifying and explaining to the client well in advance the conversion arrangement and its timing. This includes notifying the client that the conversion will be immediate, the market rates used to determine the conversion, and the identity of the payment processor. This extra step helps avoid any later dispute about the conversion since there is no single market price for a cryptocurrency, and different payment processors may convert the currency at different prices. One example of an index that processors may use is the New York Stock Exchange Bitcoin Index (NYXBT). Ultimately, it is up to the attorney to educate the client about the conversion process to ensure the client provides informed consent to the arrangement, regardless of the client’s familiarity with cryptocurrency.
A second concern addressed by the committee are situations where the client arranges for a third party to pay the client’s fees. In those cases, attorneys must keep in mind their professional obligations to accept payment from a third party only if the arrangement would not interfere with the attorney’s independence or relationship with the client, nor interfere with the client’s confidential information. This is particularly important given the history of cryptocurrency, which has allegedly facilitated easy, anonymous payments for illegal conduct and goods.
The committee correctly noted the challenges that arise with identifying a third party payer. Crypto transactions are pseudonymous in nature. This makes it nearly impossible for an attorney to determine the source of the funds. Attorneys who accept payments from third parties should comply with “Know-Your-Customer” (KYC) procedures that include certain verification steps. For example, while not directly applicable to attorneys who simply receive cryptocurrency payments, the U.S. Treasury Department’s FinCEN has issued guidance for exchanges to prevent and report money laundering activities. See FIN-2013-G001, Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (Mar. 18, 2013). At a minimum, attorneys should consider larger payment processors and exchanges like Coinbase, which require the payer to comply with KYC verification and actively take steps to prevent money laundering.
Many other situations, however, will require the attorney to request sufficient information from the third party payer prior to acceptance of the digital currency payment. At a minimum, it is important for attorneys to ask themselves, why does the client want to pay in crypto and is the client trying to avoid something by doing so? Some firms limit the risks by only agreeing to accept crypto payments from long-term clients or companies, and not from individuals. If you cannot perform satisfactory due diligence, the ABA suggests you walk away. See American Bar Association, “A Lawyer’s Guide to Detecting and Preventing Money Laundering”, 2014.
A third concern addressed by the committee is holding digital currencies in trust for clients or third parties. If a lawyer receives cryptocurrency intended to reflect a retainer to be drawn upon when fees are earned in the future, the lawyer must immediately convert the cryptocurrency into U.S. dollars. In other trust account transactions, the committee advised lawyers to inform clients that the cryptocurrency is more akin to property and will be held and not converted into U.S. dollars or other currency. Since there is no mechanism to reimburse clients if a hacker steals them, an attorney opting to receive crypto must take reasonable security precautions. In State Bar Opinion No. 2010-179, the California Bar advised attorneys to educate themselves about proper security procedures before transmitting or storing confidential client information. Attorneys likely have similar obligations for holding a client’s cryptocurrency.
The future of cryptocurrency remains volatile and uncertain. The Nebraska advisory committee’s opinion has been criticized for its failure to provide new solutions for handling cryptocurrency transactions. New ethical rules and guidelines seem inevitable. Attorneys who accept or transact in cryptocurrency must do so well informed, alert to the ethical implications.